Trading stocks? Learn basic price chart reading to help identify support and resistance and market entry and exit points.
Question: How do you know when a stock stops going up? Answer: When it starts going down (or sideways).
Ouch. Yes, we’re being a little sarcastic, but for good reason. There’s a simple truth in that sharp tone.
Learning about stock price behavior starts with taking a closer look at, well, stock price behavior. A price chart happens to be the first tool that every technical trader needs to learn. If you’re just learning how to read stock charts, it’s easy to become overwhelmed with the many looks and uses of technical analysis and charting. Here, we’ll simplify things by narrowing the choices down to the three most common chart types. Then we’ll examine some of the more popular techniques that traders apply.
Price charts visualize the trading activity that takes place during a single trading period (whether it's five minutes, 30 minutes, one day, and so on). Generally speaking, each period consists of several data points, including the opening, high, low, and/or closing price. When reading stock charts, traders typically use one or more of the three types—line, bar, and candlestick—shown in figure 1.
LINE CHART
Perhaps the most basic price chart is the line chart. It plots a single line that connects all the closing prices of a stock for a certain time interval.
It’s simple to follow, but the line chart may not tell the trader much about each day’s activity. It will, however, help the trader see trends easily and visually compare the closing price from one period to the next. Because many brokerages place the valuation of an account on the closing price, this method has some value when correlating a stock’s trend or overall performance to the market, without being too concerned about intraday fluctuations.
BAR CHART
The bar chart is another way to chart price activity (figures 1 and 2).
Bar charts help a trader see the price range of each period. Bars may increase or decrease in size from one bar to the next, or over a range of bars. Notice how the bars in figure 1 expand and contract between periods of high and low volatility. As the market becomes increasingly volatile, the bars become larger and the price swings further. As the market becomes quieter, price typically contracts into smaller bars.
The fluctuation in bar size is because of the way each bar is constructed. The vertical height of the bar reflects the range between the high and the low price of the bar period (see figure 2). The price bar also records the period's opening and closing prices with attached horizontal lines; the left line represents the open and the right line represents the close.
CANDLESTICK CHART
The candlestick chart (see figures 1 and 2) is a variation of the bar chart. Candles help visualize bullish or bearish sentiment by displaying distinctive "bodies" that are green or red, depending on whether the stock closes higher or lower than the open. The body represents the range between the opening and closing prices of the time intervals, while the high and low of the candlestick are called the wick or shadow (see figure 2).
Candles help the analyst see how prices move in a trending market. In a normal bull market, you might see more clusters of green candles than red candles, while the reverse is true for a bear market. Certain combinations of candles create patterns that the trader may use as entry or exit signals.
It’s one thing to know what a chart is. It’s another to actually to know how to read a chart.
As you can see in figure 3, stocks that move up over a period of time are essentially in uptrends; stocks that move down over a period of time are in downtrends.
Support is essentially a floor for stock prices. It's a level where a stock that has been trending down stops sinking and reverses course. At some point, the sellers stop selling, the buyers take control, and the stock starts rising again. At this inflection point, the stock puts in a low price that we call “support.” After a rally, if the stock reverses course once again and starts to come back down to test the support level, it will likely require significantly more conviction (i.e., volume) by sellers to penetrate the level and push down through support. If the stock does not penetrate support, this only strengthens the support level and provides a good indication for short sellers to rethink their positions, as buyers will likely start to take control.
Resistance is the exact opposite of support. It acts as a ceiling for stock prices at a point where a stock that is rallying stops moving higher and reverses course. Buyers will need more conviction to penetrate resistance levels in future rallies.
It’s important to understand that support and resistance are merely psychological levels, but they can nevertheless be useful for traders who are developing a trading plan.
Within a stock chart, certain repeatable patterns may appear that can provide clues to help determine where a new trend begins and ends. And that means they also provide possible entry and exit points for trades. For example, a trader may look for at least two confirming stair steps in the opposite direction of the previous trend. If a stock has been trending down and suddenly reverses, before it can be called an uptrend (instead of merely a short bear market rally or “dead cat bounce”), look for confirmation in the chart pattern—at least one higher high than the first, and one higher low than the lowest price of the previous trend.
There are many breakout patterns that can provide useful entry and exit points. Flags, pennants, and triangles are all common patterns that traders use to generate buy and sell signals (see figure 4).
Is the stock you’re watching moving up or down? Who is doing the buying or selling? When is a good time to get into a trade? To answer these questions, technical traders typically use multiple indicators in combination. The theory is that individual indicators will provide false signals that could lead to poor entries and big losses. A more powerful system uses a combination of indicators to confirm one another. Traders stay out of potentially harmful trades more often if there are conflicting signals among indicators.
Where to start? Try learning how volume and moving averages work together with price action, and then add or subtract indicators as you develop your own system.
Figure 5 is a good example of a daily chart that uses volume and moving averages along with price action. It shows how a trader might determine support and resistance levels (gray lines). The volume indicator is below the chart; two moving averages (10-day and 30-day) are drawn over the candles inside the chart. Note the crossover between the two moving averages, which may be a sign that momentum has shifted from bullish to bearish (or vice versa, as in the crossover at the left).
There are several different types of price charts that traders can use to navigate the markets, and an endless combination of indicators and methods with which to trade them. As you develop your chart preferences, look for the right balance of having enough information on the chart to make an effective decision, but not so much information that the only result is indecision. Too few indicators can lead to false signals and poor choices, whereas too many can lead to “analysis paralysis” where no trading signal is ever given.
Keep things simple as you begin reading stock charts. Finding the right combination is different for every trader, so it’s important to start with the basics and work your way into using the indicators and patterns that make the most sense to you.